Bills Digest No. 192  1999-2000New Business Tax System (Miscellaneous) Bill (No. 2) 2000


Numerical Index | Alphabetical Index

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History
Purpose
Background
Main Provisions
Endnotes
Contact Officer & Copyright Details

Passage History

New Business Tax System (Miscellaneous) Bill (No. 2) 2000

Date Introduced: 13 April 2000

House: House of Representatives

Portfolio: Treasury

Commencement: Upon Royal Assent. However, the measures contained in the Bill have different application dates, which will be considered in the Main Provisions section of this Digest.

Purpose

The amendments contained in this Bill are:

  • measures to amend the company loss and bad debts provisions (Schedule 1)
  • measures to impose tax on life insurers and superannuation funds (Schedule 2)
  • measures to amend the imputation system to provide franking credits and debits for the 'pay-as-you-go' instalments system and the proposed taxation of life insurance companies (Schedule 3)
  • measures to amend the capital gains provisions on cost base adjustments for certain interests in trusts (Schedule 4)
  • measures to amend the capital gains provisions for the proposed 'scrip for scrip' roll-over provisions (Schedule 5)
  • technical amendments relating to excess deductions for mining or exploration expenditure (Schedule 6)
  • measures to impose anti-avoidance rules for the 'pay-as-you-go' instalments system (Schedule 7)
  • technical corrections relating to deducting prepayments (Schedule 8), and
  • consequential amendment of the dictionary provision of the Income Tax Assessment Act 1997 (Schedule 9).

Background

As this Bill has no central theme the background to the various measures is included in the discussion of the main provisions. The main provisions are considered in the order of significance.

Main Provisions

Scrip for scrip roll-over relief (Schedule 5)

The measures in Schedule 5 extend the scope of the scrip for scrip capital gains tax exemption.

Background

The exchange of shares in a target company for shares in the takeover company is called a 'scrip for scrip' takeover because the takeover company provides its shares to shareholders of the target company in exchange for their shares in the target company. 'Roll-over relief' is a tax concession provided in the form of deferral; although a tax event has taken place recognition of the event is deferred until a later time. For example, if a company proposes to takeover another company, by offering the shareholders of the target company a set price per share, the sale of shares is a tax event for those shareholders who accept the offer. Any gains made by shareholders from the sale of the shares will generally be assessable as either income or capital gains. Alternatively, the consideration for acquiring the shares may be shares in the takeover company (a scrip for scrip offer). Without roll-over relief, a scrip for scrip takeover results in a tax event for the shareholders of the target company and the gains they make from the exchange are assessable. In a scrip for scrip takeover, the shareholders of the target company would be required to pay tax on their notional gains even if the realisation was involuntary.

Business Tax Review

The report of the Review of Business Taxation titled 'A Tax System Redesigned' contained recommendations that scrip for scrip roll-over provisions be included in the income tax law.(1) Chair of the Review of Business Taxation was Mr John Ralph, AO and the report is known as the Ralph Review. The Ralph Review contains the following comments leading to its scrip for scrip recommendations:

360 The business community has long claimed that the absence of CGT rollover relief for scrip-for-scrip takeovers between companies was a major barrier to rationalising of Australian business and the realisation of significant efficiency gains.

361 Rollovers will be allowed for scrip-for-scrip transactions involving takeovers where at least 80 per cent of the target entity is held on completion and at least one of the entities involved is widely held.

362 This change is expected to allow a significant rationalisation of many Australian businesses with consequent benefits in terms of economic growth, returns to shareholders and employment. It will also allow start-up and early stage businesses to be acquired by widely held entities without triggering capital gains tax for the entrepreneurs until they realise their investments, thereby encouraging new ventures.(2)

The Minister's second reading speech described the scrip for scrip roll-over relief as one of the Government's key business tax reforms. It states that the measure 'removes a major impediment to mergers and takeovers and allows start-up and innovative firms to undergo restructuring without triggering a capital gains tax liability.'(3) The measure applies to companies regardless of whether the shares are in widely held or private companies. The scrip for scrip roll-over relief commenced on 10 December 1999.

Scrip for scrip roll-over

The existing scrip for scrip roll-over relief provisions are contained in Subdivision 124-M of the Income Tax Assessment Act 1997 (the 1997 Act).(4) They provide capital gains tax roll-over relief for shareholders in companies or beneficiaries of fixed trusts who exchange their interests in a target company for interests in an acquiring company or trust as part of a takeover. This reform was part of the agreement between the Government and the Opposition on the Government's business reform package.(5) Without the roll-over relief, shareholders in a target company accepting a scrip for scrip offer would be subject to tax on any accrued capital gains in respect of the exchanged shares.

The existing scrip for scrip roll-over relief provisions were subject to controversy because there is uncertainty as to whether they would apply to schemes of arrangement.(6) The arrangement and reconstruction provisions of the Corporations Law provide for a scheme of arrangement takeover mechanism. Under this procedure, the shareholders of the target company must approve the scheme by special majority and then the scheme must be approved by a court. If the scheme is successful it is binding on all members and creditors of the target company. It has been reported in the press that Treasury officers and members of the Ralph Committee have stated that this shortcoming in the existing legislation was an unintended consequence.(7) This error in the existing legislation is surprising as Ford's Principles of Corporations Law (9th edition) lists three methods of corporate takeover.(8)

Proposed amendments

Extension of roll-over relief to schemes of arrangement

Under the existing legislation a takeover entity must make an offer to the shareholders of the target company or the unit holders of a target trust. As stated above, the existing roll-over relief does not apply to schemes of arrangement or the cancellation of original interests in a company or trust because in these situations an offer is not made to shareholders or unitholders. Proposed section 124-780 purports to extend roll-over relief to these situations (Item 4). To be eligible for roll-over relief the arrangement must result in the acquiring entity owning at least 80 per cent of the target entity (proposed paragraph 124-780(2)(a)).

Roll-over relief extended to 'downstream' company acquisitions

The existing scrip for scrip roll-over relief provisions require shareholders to exchange their shares in the target company for shares in the acquiring company. The Explanatory Memorandum states that it is common commercial practice for a subsidiary company in a company group to acquire a target company by offering as consideration shares in the subsidiary's holding company.(9) This is described as being a 'downstream acquisition'. The existing provisions do not provide roll-over relief for downstream acquisitions. The measures will provide roll-over relief for downstream acquisitions. Proposed subparagraph 124-780(3)(c)(ii) provides that the replacement shares may be shares in the ultimate holding company. The term 'ultimate holding company' is defined in proposed subsection 124-780(7) as being a company that is not a 100 per cent subsidiary of another company in the group.

Roll-over relief for certain pre-CGT interests

Capital gains tax is restricted to property acquired on or after 20 September 1985. Property acquired before 20 September 1985 is called pre-capital gains tax property. Post capital gains tax property is property that has been acquired by a taxpayer on or after 20 September 1985.

If a taxpayer acquired shares or units in a trust before 20 September 1985, any capital gain or loss made in respect of the shares or units is excluded from capital gains tax because the shares or units are pre-capital gains tax property. However, a capital gains tax liability may arise in respect of pre-capital gains tax shares or units if the transaction results in a gain being made under capital gains tax event K6 (section 104-230 of the 1997 Act). This event arises if at the time of disposal of an interest in a company or trust, 75 per cent of the net value of the company or trust is represented by post capital gains tax property. This is designed to prevent tax avoidance through the use of pre-capital gains tax shares or units where 75 per cent of the underlying property in the company or trust are post-capital gains tax assets. Under capital gains tax event K6, a taxpayer's capital gain is limited to the gains that are attributable to the post-capital gains tax property held by the company or trust. It does not apply to gains that are attributable to pre-capital gains tax property acquired by the company or trust.

Proposed subsection 104-230(10) provides roll-over relief to a taxpayer who acquired shares or units before 20 September 1985 and those shares or units have become subject to capital gains tax under capital gains tax event K6. This is achieved through treating the shares and units as post capital gains tax assets. If, in this notional situation the taxpayer would have been entitled to scrip for scrip roll-over relief, the taxpayer is then treated as being eligible for roll-over relief for the pre-capital gains tax shares or units (Item 2).

Proposed section 124-800 will provide for the cost base of the replacement shares or units to be reduced to take account of the roll-over relief (Item 10). The reduced cost base will result in the taxpayer's unrealised capital gains being deferred until the taxpayer disposes of the share or units.

Avoidance concerns with section 23AJ of the 1997 Act: Restrictions placed on non-resident companies

The existing scrip for scrip roll-over relief applies to takeovers where the target company and acquiring company are non-resident companies.(10) According to the Explanatory Memorandum there are concerns that this may provide for tax avoidance for closely held non-resident companies. (11)The explanation of the tax avoidance opportunities arising from the use of the scrip for scrip roll-over relief with closely held non-resident companies is not clear. (12)

The Explanatory Memorandum asserts that the exemption for foreign dividends will be protected by requiring the ownership of the entities to be widely held.(13) Proposed subsections 124-795(4) and (5) require the target company and the takeover company to have at least 300 members (Item 9). The term 'members' is defined in subsection 995-1(1) as including a shareholder or stockholder. The widely distributed category of shares may not be effective in preventing a closely held non-resident company from represent itself as being widely held. The effective administration of this measure requires access to information on shareholders of non-resident companies that the Australian Taxation Office may not be able to easily verify. Nevertheless, the perceived tax avoidance opportunities have not been thoroughly explained. If an avoidance opportunity does exist then the proposed measures in Item 9 would appear to be capable of being avoided. The Explanatory Memorandum does acknowledge this point by stating the proposed measure will only lower the risk of abuse.(14) In addition, the Explanatory Memorandum states that the availability of the exemption for non-resident companies will be considered in the review of the foreign source income rules.(15)

Application

Once the Bill is passed, the measures in Schedule 5, apart from Item 9, will have commenced on 10 December 1999, the commencement date for the scrip for scrip roll-over relief. Item 9, the measures dealing with non-resident companies, will commence on 13 April 2000, the day of introduction of this Bill.

Taxation of Life Insurance Companies (Schedule 2)

The measures in Schedule 2 will broaden the tax base by imposing income tax on life insurance companies and will change the current basis of taxing the pension business of superannuation funds.

Background

Life insurance entities are registered under the Life Insurance Act 1995. A life insurance policy is a business a life insurance company is able to carry on as provided under the Life Insurance Act 1995.

The Government announced in Tax Reform, not a new tax, a new tax system that it would reform the tax treatment of life insurance entities.(16) The paper stated:

Under the entity tax regime, from 2000-01 income year, the company tax rate would apply to a life insurer's income and deductions generated in relation to :

  • ordinary life insurance business - presently taxed as a separate trustee tax rate (39 per cent for life insurance companies and 33 per cent for friendly societies);
  • policies held by superannuation funds - both complying (currently 15 per cent) and non-complying (33 per cent);
  • contractual obligations on annuities contracts - with a deduction allowed for the 'interest' component of annuity payments and associated expenses. Income from this business is currently exempt and associated deductions are not allowed.

. . .

These reforms would improve the efficiency of the financial system and further the objectives of the financial system reform. They would also improve the certainty of the taxation treatment that applies to life insurers. Life insurers, for example, would not longer need to undertake complex and costly allocations of income and deductions into different tax 'baskets'.(17)

The taxation of life insurance entities was considered in the Ralph Review.(18) The Ralph Review asserted that it had consulted widely on the basis of the above proposals and its recommendations are broadly in line with these proposals.(19) The Review recommended, inter alia:

That the activities of life insurers be taxed neutrally in relation to comparable activities, with taxable income being calculated:

  1. from risk business - on the same basis applying for taxable income of the risk business of general insurers;

  2. from investment business - on the same basis applying for taxable income of the investment business of other investment activities; and

  3. from complying superannuation business - on the same basis applying for taxable income of pooled superannuation trusts.(20)

Proposed measures

The new rules for the taxation of life insurance companies are contained in proposed Division 320 (Item 84). Proposed section 320-1 provides an outline of proposed Division 320 on the taxation of life insurance companies. The outline states that the Division provides for the taxation of life insurance companies in a broadly comparable way to other entities that derive similar types of income. The proposed Division contains special rules for working out the taxable income of life insurance companies. The taxable income of life insurance companies is divided into two classes: the complying superannuation class; and ordinary class. The proposed Division also contains rules for segregating assets of life insurance companies into: assets that relate to complying superannuation business; and assets that relate to immediate annuity and other exempt business.

Assessable income of a life insurance company

Proposed section 320-15 lists what gains are to be included in the assessable income of a life insurance company. The list includes the following amounts:

  • life insurance premiums paid to the company (proposed paragraph (a))
  • amounts received under a contract of reinsurance to the extent to which they relate to the risk components of claims paid under life insurance policies (proposed paragraph (b))
  • amounts received that are a refund of a life insurance premium paid under a contract of reinsurance (proposed paragraph (c)), and
  • amounts received under a profit sharing arrangement in relation to a contract of reinsurance (proposed paragraph (d)).

The list includes certain other assessable amounts.(21) The definition in proposed section 320-15 is an inclusive definition rather than being an exhaustive list of assessable amounts. Consequently certain other amounts that are assessable as ordinary income(22) under section 6-5 and statutory income(23) under section 6-10 of the 1997 Act may also be included in the assessable income of an insurance company. For example, the assessable income of a life insurance company will include fees charged by life insurance companies such as premiums.

Exempt income of a life insurance company

Proposed sections 320-35 and 320-40 list the exempt income of a life insurance company. Proposed section 320-35 lists certain amounts that are to be treated as exempt income. Proposed section 320-40 is a transitional measure. It provides that one third of specified management fees on certain life insurance policies taken out before 1 July 2000 will be exempt from tax. Under proposed subsection 320-40(2) the exemption provision ceases to apply from 30 June 2005. The Explanatory Memorandum states that the reason for this limited concession is because currently a full deduction is not allowed for policy acquisition expenses to the extent that associated management fees are not taxed at the company tax rate.(24) These acquisition expenses are recovered from fees charged on a policy in its initial years of operation. These fees will now be taxed at the company rate of tax.

Specific deductions available to life insurance companies

Proposed subdivision 320-C specifies particular deductions that are available to a life insurance company. It also specifies particular amounts that a life insurance company cannot deduct and contains provisions relating to a life insurance company's capital losses.

Self managed superannuation funds - transfer of assets to or from certain asset categories

The measure over which there is controversy is the proposal to tax the conversion of superannuation assets in self managed small superannuation funds (Item 43 of Schedule 2). Proposed Division 1A of Part IX of the 1936 Act will create a tax liability when a taxpayer converts an accumulation asset to a pension asset. At present such asset transfers do not give rise to a tax consequence in small superannuation funds but larger superannuation funds are subject to capital gains tax on the conversion. This measure will create neutrality between small self managed funds and other superannuation funds. Under the current rules small superannuation funds have an advantage as they are not subject to capital gains tax on conversion. Complying superannuation funds are subject to tax on capital gains at the concessional rate of 10 per cent.

Proposed section 273H applies if:

  • an asset, other than money, is transferred to the segregated current pension assets of a complying superannuation fund or segregated exempt superannuation assets of a PST [pooled superannuation trust](25) under proposed subsections 273C(1), 273G(1) or (2), or
  • an asset other than money is transferred to the segregated current pension assets of a complying superannuation fund or segregated superannuation assets of a PST under proposed subsections 273C(2), 273D(1), (4), (5) or (6).

Proposed subsection 273H(2) creates a legal fiction for the purpose of determining the income tax or capital gains tax consequences of an asset transfer within the scope of proposed subsection 273H(1). The legal fiction is that the fund or PST sold the asset immediately before the transfer for its market value and that it purchased the asset immediately after the transfer for its market value. Once this legal fiction is applied an income tax liability or capital gains tax liability will arise. It may result in an assessable gain or a deductible loss.

For a complying superannuation fund, proposed section 281 includes in the fund's assessable income the amount that is treated as being assessable because of proposed section 273H. Deductions are also available to a complying superannuation fund under proposed section 273H. Proposed sections 281AA and 281B contain the rules for determining a fund's deduction.

For a PST, proposed section 296A includes in the PST's assessable income, the amount that is included in its assessable income because of proposed section 273H. Proposed section 273H, proposed sections 296AA and 296B contain the rules for determining the fund's deduction.

Media Comments on the proposed measures

The taxation of asset conversions in small superannuation funds was viewed as being unfair by the Association of Superannuation Funds of Australia (ASFA) and the Australian Society of Certified Practicing Accountants (CPAs). ASFA agrees with the principle underlying the measure but suggests that the measure should be phased in.(26) It has stated that in its view the application of capital gains tax on conversion in small funds is retrospective because taxpayers nearing retirement did not expect to be subject to the tax. ASFA has suggested that this measure be phased in with the following concession:

Exempt for CGT the pre-1 July 2000 capital gain of an asset that was held directly by a SMSF or a small APRA fund (SAF) on 13 April 2000, where the following conditions are met:

  • The asset is held in a fund that is converted from an accumulation fund to a pension fund prior to 1 July 2005;
  • The fund has a valuation for the asset showing its value on 1 July 2000.(27)

The CPAs argue that the proposal to tax asset conversions will conflict with the Government's aim of encouraging taxpayers to save for retirement.(28) They argue that the measure will disadvantage taxpayers in small superannuation funds seeking to convert an accumulation amount into a pension benefit. The CPAs have not, however, suggested an alternative method of treating both small superannuation funds and large superannuation funds in the same manner for asset conversions. It has also been suggested by an adviser that self managed superannuation funds may be able to offset any capital gains tax liability that arises from asset transfers by using available dividend imputation credits.(29)

In relation to the overall effect of subjecting life insurance companies to income tax, AMP (Australia's biggest life insurance underwriter) has estimated that the reforms could cause it to pay between $73 million to $250 million per year in tax,(30) and reduce its capital value by $1 billion.(31) AMP prepared these estimates before the Bill was introduced. AMP was reported as stating that the impact of the proposed measures will depend on its ability to re-price its products, to improve the capital efficiency of products in its life funds and to write more business outside life insurance.(32)

Application

  • Items 25 and 26 of Schedule 2 commence on 1 July 2000, immediately after the commencement of Subdivision D of Division 3 of Part 3 of the Taxation (Deficit Reduction) Act (No. 2) 1993.
  • Items 67 and 68 and 70 of Schedule 2 commence on 1 July 2001.
  • Items 114 and 116 of Schedule 2 commence immediately after the commencement of items 36 and 37 in Schedule 4 to the A New Tax System (Taxation Administration) Act (No. 2) 2000.

Concluding comments

The capital gains tax on the conversion of accumulation funds to pension funds

The measure to impose capital gains tax on the conversion of accumulation funds to pension funds will introduce neutrality between large superannuation funds and small self managed funds. The Explanatory Memorandum considers this issue in a purely technical manner. It does not mention the policy behind the measure nor that it appears to be intended to close a tax avoidance opportunity available to small superannuation funds.

While small superannuation funds have been able to convert accumulation assets into pension assets without any capital gains tax consequences, this concession was not intentional and appears to have been a shortcoming in the existing legislation. As the concession has been available up until now, many taxpayers have made their retirement plans on the basis that capital gains tax would not applicable to the conversion. It is difficult to see that the present arrangement could be seen as a tax incentive, rather it is the exploitation of a shortcoming in the existing law. The ASFA proposal seeks to grandfather the measure for 5 years. Moreover, the ASFA proposal accepts the merit in making the taxation of asset conversions in superannuation funds neutral. The ASFA proposal is balanced and does offer the compromise of grandfathering the concession for a set period of time.

On the other hand, it may be argued that this shortcoming in the tax law should be closed as soon as possible to create neutrality between large and small superannuation funds. Members of small superannuation funds who proposed to use the shortcoming should have been aware that they were relying on the Government to leave standing the capital gains tax avoidance opportunity rather than enjoying a tax benefit targeted at them. It is difficult to see why a liability for tax should turn on the size of the superannuation fund. Members of large superannuation funds may feel that horizontal equity requires that members in the same economic circumstances should be treated in the same manner. The downside of leaving the measure as it stands is that members of small superannuation funds who were not intending to retire in the near future may decide to retire before the application date of 1 July 2000 and avoid being subject to the proposed measures.

The provisions in Schedule 2 are complex and difficult to understand. It has been reported that:

the bill has been branded as so complex as to be a nightmare' . . . At a time when the chains of complexity are supposed to be falling from the tax system, it [Schedule 2 of the bill] imposes new provisions which will confuse and complicate retirement income.(33)

In a self assessment tax system this failure to provide simple legislation imposes significant compliance burdens on taxpayers. The costs of compliance will generally be passed on to the consumers of life insurance policies in the form of higher premium fees.

Terms used in proposed Division 320

Proposed Division 320 uses the term 'virtual' instead of the term 'notional' to indicate that certain classifications are legal fictions for tax purposes. This use of the term is unusual. The term 'virtual PST' is defined in Item 68 of Schedule 9 as 'a virtual pooled superannuation trust'. The term 'virtual pooled superannuation trust' is defined in Item 67 of Schedule 9 as having the meaning given by proposed subsection 320-170(6). This provision states that 'assets from time to time segregated are together to be known as a virtual pooled superannuation trust or virtual PST and each asset from time to time included among the segregated assets is to be known as a virtual PST asset'. The term virtual is defined in The Macquarie Dictionary as:

(1) being such in power, force or effect, although not actually or expressly such . . . (2) Optics. a. denoting an image formed by the apparent convergence of rays geometrically (but not actually) prolonged as the image in a mirror (opposed to real) . . . (3) Computers of or relating to someone or something which exists in virtual reality.(34)

It would appear that the use of the term 'virtual' in Schedule 2 as an adjective is based on the concept of virtual reality. The term 'virtual' in the above legislative definition appears to indicate that a pooled superannuation trust is a notional characterisation. The term 'notional' would appear to be a better term to use to indicate that a certain classification is fictional. Moreover, the term 'notional' is also used in the Bill and is used in the 1997 Act, it would be preferable if consistent terminology were used to refer to legal fictions.(35)

Company losses and bad debts (Schedule 1)

The measure in Schedule 1 seeks to prevent the multiple recognition of a company's losses on the realisation of either equity or debt interests held directly or indirectly in a loss company that has had an 'alteration'. An 'alteration' is a change in the company's ownership or control, or a declaration by a liquidator that a company's shares are worthless. The scope for tax avoidance arises because the loss company's value is reflected in the value of its shares. This allows those entities with a direct and indirect interest in the loss company to revalue the shares and recognise the reduced value of their holding in the shares of the loss company. This will enable them to also claim a loss.

Background

The Ralph Review considered the issue of duplication of losses and made the following comments:

The possibility of multiplication of the loss needs to be addressed ... where entities are interposed between individual shareholders and a loss entity (an entity with realised or unrealised tax losses). Losses on the membership interests in the interposed entities will be denied to the extent of the tax losses in the loss entity. That is illustrated in Figure 6.1. This will prevent multiplication of losses up an entity chain. The tax value of any inter-entity membership interests in a loss entity will be reduced by the loss entity's realised and unrealised tax losses (net of unrealised gains) when there is a change in the loss entity's majority underlying ownership. The reduction in tax value will be made in respect of direct and indirect interests in the loss entity. The requirement to reduce tax values may be negated to the extent that it can be demonstrated that the loss asset has not impacted on the market value of the interests in the entity.(36)

The Ralph Review contained the following recommendation:

That the same business test be retained, subject to the removal of inter-entity loss multiplication.(37)

The measures in Schedule 1 implements the above recommendation. According to the Explanatory Memorandum, the measures seek to strike a balance between preventing avoidance and minimising compliance costs.(38) This is addressed by restricting the measures to entities which are direct or indirect controllers of a loss company, and have a significant interest in the loss company.

The measures apply to entities which, either alone or together with associates, are controllers of the loss company. The measures will not apply to individuals, or entities which hold interests on behalf of individuals. The measures will require a controlling entity to reduce its deductions and capital gains tax cost bases in relation to significant interests held in the loss company.

Proposed measures

Proposed section 165-115J states that the main object of proposed subdivision 165-CD is to make appropriate adjustments to the tax values of significant equity and debt interests held directly or indirectly by entities in a loss company whose ownership or control changes (Item 18). The aim of the adjustments is to prevent the duplication of the loss company's realised and unrealised losses when the significant equity and debt interests are realised. This is because the realised and unrealised losses of the loss company are reflected in the value of the significant equity and debt interests.

Proposed subdivision 165-CD applies if the following requirements in proposed subsection 165-115K(1) are satisfied:

  • an 'alteration time' occurs in respect of a company (proposed paragraph (a))
  • the company is a loss company (proposed paragraph (b))
  • one or more entities had significant equity or debt interests in the loss company (proposed paragraph (c)).

The 'alteration time' is defined in proposed section 165-115L as being an alteration in the ownership of a loss company. The alteration time is defined in proposed section 165-115M as being an alteration in the control of a loss company. An alteration time is also a statement by a liquidator that shares in a company are worthless (proposed section 165-115N). An 'affected entity' is one that, either alone or together with associates has a 'controlling stake' in a company. A 'loss company' is defined in subsection 16-115R(3) as being a company which has either an undeducted tax loss or an unapplied net capital loss.

A 'relevant equity interest' is defined in proposed section 165-115X as being a direct or indirect interest of at least 10 per cent in the loss company. The equity interests are:

  • control of at least 10 per cent of the voting power of the loss company (proposed subparagraph (1)(i))
  • the right to receive at least 10 per cent of the dividends (proposed subparagraph (1)(ii)), and
  • the right to receive at least 10 per cent of the distribution of the capital of the loss company (proposed subparagraph (1)(iii)).

The threshold of 10 per cent in the above tests is low. In setting a control test at this level, some entities may be treated as being controllers under the legislation when in fact they do not have real control of the loss company. Moreover, setting the threshold at this level may result in several independent shareholders being treated as the controllers of a loss company.

The proposed measures require an entity, called an 'affected entity', to make 'adjustments' to 'significant debt and equity interests' it has in a company that has realised and unrealised losses if an event, called an 'alteration time', takes place in respect of a 'loss company'. An affected entity is defined as being an entity that has a relevant equity interest or debt interest, or both, in a loss company immediately before an alteration time (proposed subsection 165-115ZA).

The 'adjustments' that an affected entity must make are adjustments to the reduced cost base for capital gains tax purposes of an affected entity (proposed subsection 165-115ZA(3)). An adjustment also includes deductions if the interests of the affected entity are held as trading assets (proposed subsection 165-115ZA(4)). An adjustment will be based on the 'overall loss' of the loss company (proposed section 165-115ZB). The 'overall loss' of the loss company is the sum of its realised losses and unrealised losses on capital gains tax assets.

Under proposed section 165-115ZC a controlling entity is required to provide information to its associates to make the required reduction under this subdivision. Penalties are imposed for a taxpayer's failure to comply with the notice requirements.

Certain exemptions are provided in proposed subdivision 165-CD to minimise compliance costs. Unrealised losses on assets acquired for less than $10,000 do not have to be calculated (proposed subsection 165-115V). An entity whose net value is less than $5 million does not have to count unrealised losses at an alteration time (proposed subsection 165-115U(2)). Proposed subsection 165-115U states that a company is treated as not having an adjusted unrealised loss if the company satisfies the maximum asset test under section 152-15 of the 1997 Act - the small business threshold test.

Application

The application provision of Schedule 2 contains the following application dates:

  • The amendments made by items 6 to 17 apply to an income tax year ending after 11 November 1999 (subitem 68(1)).
  • The amendments made by items 3 to 5, 20 to 22, 24 to 29, 31 to 33 and 34 to 36 apply to an income tax year ending after 21 September 1999 (subitem 68(2)).
  • The amendment made by item 30 applies for the purpose of determining whether a time after 11 November 1999 is a changeover time or alteration time in respect of a company (subitem 68(3)).
  • The amendments made by items 37, 39, 43, 46 to 50 and 54 apply where the agreement transferring the relevant tax loss or net capital loss was made on or after 22 February 1999 (subitem 68(4)).
  • The amendments made by items 41, 42, 44, 52, 53 and 55 apply where the agreement transferring the relevant tax loss or net capital loss was made on or after 13 April 2000 (subitem 68(5)).
  • The amendments made by items 56 to 65 are taken to have applied, or apply, to CGT events happening on or after 21 October 1999 (subitem 68(6)).

Concluding comments

The provisions are complex and there are significant penalties for non-compliance. Taxpayers who are unaware that they are within the scope of the provisions may face significant penalties even if their activities were not influenced by tax avoidance motives. It could be expected that because of the complex provisions in Schedule 1 some taxpayers may come within its scope and be unaware of the tax consequences.

While one of the aims or the Taxation Law Improvement Project was to renumber the income tax law with an open numbering system to prevent the use of letters in legislation, Division 165 has already reached the situation where two letters are being used in provision numbers (e.g. proposed section 165-115ZB). It is likely that we will soon be back to the situation in which several letters are used in provision numbers. It would appear that the open numbering system after only a few years has been exhausted in certain divisions of the 1997 Act. Moreover, we have two tax Acts, the 1936 Act and the 1997 Act which adds further complexity. The process of redrafting the 1936 Act has been postponed by the tax reforms and paradoxically many of the tax reforms are amendments of the 1936 Act. This will give rise to the need for these reforms to be redrafted in the future into the 1997 Act.

The exemptions in Schedule 1 are poorly signposted. Proposed section 165-115 states that two exemptions are available. One of the exemptions is the asset value of a company being less than $5,000,000 but that term is not used again in Schedule 1. The provision implementing this exemption instead refers to a company that satisfies the 'maximum net asset value test in section 152-15' (proposed subsection 165-115U(2)). In these situations parallel construction needs to be used. Both provisions should use the same terms, rather than using a monetary value in an overview provision, and the name of a test in the operative provision. Moreover, the flow chart in proposed section 165-11H does not refer to the exemption provision. An effective flowchart should signpost the exemption provisions so that taxpayers who are exempt from the scope of the proposed measures may easily determine their tax obligations. The requirement that taxpayers be able to understand tax legislation is even more vital given Australia's self assessment tax system.

Pay-As-You-Go (PAYG) instalments: anti-avoidance rules (Schedule 7)

The measures in Schedule 7 propose to amend the object provision of the PAYG instalments system and to introduce anti-avoidance rules for the PAYG system.

Background

The PAYG instalment system will replace the existing provisional tax system. The aim of the PAYG system is: to get business entities paying their tax liabilities at the same time; to allow taxpayers with fluctuating incomes to make payments more closely aligned with their income receipts; and to collect instalments after the end of each quarter based on the income earned in the quarter. The design of the proposed anti-avoidance provisions is similar to Part IVA of the 1936 Act, the general anti-avoidance provisions of the income tax law.

Proposed measures

Proposed section 45-5 of Schedule 1 of the Taxation Administration Act 1953 (the Administration Act) states that the object of the proposed PAYG instalment anti-avoidance rules is to ensure the efficient collection of taxes and levies through the application of principles set out in the provision (Item 2). The principles are:

  • as a taxpayer earns instalment income, the taxpayer will pay instalments after the end of each quarter worked out on the basis of the taxpayer's instalment income for that quarter (proposed subsection 45-5(2))
  • the total of a taxpayer's instalments for an income year must be as close as possible to the total of the taxpayer's liabilities for an income year (this does not apply to capital gains) (proposed subsection 45-5(3)), and
  • when instalments are payable, and how their amount is calculated, are the same for different kinds of entities, except as expressly provided (proposed subsection 45-5(6)).

The PAYG anti-avoidance rules are in proposed subdivision 45-P of Schedule 1 of the Administration Act (Item 3). Proposed subsection 45-595(1) states that the object of subdivision 45-P is to penalise an entity whose PAYG tax position is altered by a scheme that is inconsistent with: the purposes and objects of this Part (see proposed section 45-5); and the purposes and objects of provisions of this Part.

The penalty imposed is the general interest charge (proposed section 45-620). The general interest charge is defined in subsection 995-1(1) of the 1997 Act as meaning the charge worked out under Division 1 of Part IIA of the Administration Act. Under proposed subsection 45-600(10), a taxpayer is liable to pay a general interest charge if:

  • the taxpayer obtained a tax benefit from a tax scheme and the tax benefit relates to a component of the taxpayer's tax position
  • the tax benefit relates to a component, and
  • having regard to the matters referred to in proposed subsection 45-600(3) it would be concluded that an entity carried out the scheme for the sole or dominant purpose of getting a tax benefit from the scheme.

Proposed subsection 45-600(3) provides that in ascertaining a taxpayer's purpose for carrying out a scheme one shall have regard to the following 10 factors:

  • the manner of the scheme
  • the form and substance of the scheme
  • the purposes and objects of this Part
  • the timing of the scheme
  • the period over which the scheme was entered into
  • the effect that the Administration Act would have in relation to the scheme apart from this subdivision
  • any change in the taxpayer's financial position that has resulted from the scheme
  • any changes in the financial position of entities connected with the taxpayer
  • any other consequence for another taxpayer or connected entity, and
  • the nature of the connection between the taxpayer and such connected entities.

If a taxpayer has obtained two or more tax benefits, proposed subsection 45-600(4) directs that this section will apply separately to each tax benefit.

Proposed section 45-605 contains the test for determining whether a taxpayer has obtained a tax benefit from a scheme and the amount of the benefit. Firstly, a taxpayer must determine the taxpayer's actual tax position for an income year (proposed subsection 45-605(2)). Secondly, the taxpayer must determine the taxpayer's hypothetical tax position for the same income year without applying this subdivision.(39) Finally, the taxpayer must compare each component of the two tax positions. If a component of the hypothetical tax position exceeds the actual tax position, the taxpayer is treated as having obtained a tax benefit. Proposed subsection 45-610 states that a tax position for an income year consists of a number of components. The components are:

  • the taxpayer's instalment for each quarter
  • a taxpayer's annual instalment for the income year
  • a credit variation, and
  • a variation in the GIC [general interest charge] component.

Proposed section 45-615 defines a taxpayer's hypothetical tax position for an income year as the taxpayer's tax position if the taxpayer had not entered the scheme.

General Interest Charge

The general interest charge is twice the tax benefit that a taxpayer has obtained (proposed subsection 45-620(1)). A taxpayer is liable to pay the general interest charge for each day in the period in which an instalment was due to be paid and finishes at the end of the day on which the taxpayer's assessed tax for the income year is due to be paid.

Under proposed section 45-625 a taxpayer may be provided with a credit if the taxpayer is liable to pay the general interest charge because the taxpayer obtained a tax benefit under a scheme but the Commissioner is satisfied that the taxpayer also suffered a detriment from the scheme.

The Commissioner is provided with a discretion under proposed section 45-640 to remit the general interest charge in special cases. To remit the general interest charge the Commissioner must be satisfied that it would be fair and reasonable to do so.

Application

Schedule 7 commences immediately after the commencement of section 1 of the A New Tax System (Tax Administration) Act (No. 1) 2000 (subclause 2(1) of the Bill).

Imputation (Schedule 3)

Pay-As-You-Go instalments (PAYG)

Part 1 of Schedule 3 provides for the creation of franking credits and debits from the payment of, and refund of tax and PAYG rate variation credits under the PAYG system. Under the existing dividend imputation system a company will receive a franking credit when it pays income tax. It receives a franking debit if it gets a tax refund. With the introduction of the PAYG system from the 2000-2001 income year, consequential amendments are required to the dividend imputation system to provide franking credits for rate variation credits under PAYG.

Life Insurance Companies

Part 2 of Schedule 3 contains measures to set out the circumstances in which life insurance companies will gain a franking credit or franking debit. (40)The events giving rise to a franking credit or franking debit are:

  • the payment and refund of tax under the new PAYG system
  • PAYG rate variation credit, and
  • the receipt of franked dividends.

Conversion of franking account balances

Part 3 of Schedule 3 deals with the conversion of franking account balances to take account of the new 34 per cent company tax rate.

Life insurance company measures

Class A franking surpluses and deficits of life insurance companies represent tax paid at a 39 per cent rate. From 1 July 2000 these companies will pay tax at a 34 per cent rate. The measures in Part 3 of Schedule 3 will close these accounts for life insurance companies. Class A franking credits and debits arising after 30 June 2000 will be converted to equivalent class C franking credits and debits reflecting the proposed 34 per cent rate.

Franking credits and debits at the 34 per cent rate arising before 1 July 2000

This measure will convert class C franking credits or debits arising before 1 July 2000 at the 34 per cent rate to equivalent class C franking credits and debits reflecting the 36 per cent rate. The amendment is required because class C franking credits at the 34 per cent rate may arise before 1 July 2000, the date on which this measure commences.

Thresholds for franking credit trading rules

Part 4 of Schedule 3 deals with changes to the threshold for the small shareholder exemption under the existing holding period rule. The holding period rules requires taxpayers to hold shares at risk for 45 days to be eligible for the dividend tax credits (franking credits). Persons with small shareholdings can obtain an exemption from the holding period rule by electing to limit their franking rebate entitlement. The existing threshold is $2,000. Proposed section 160APHT of the 1936 Act will increase the threshold to $5,000 (Item 98 of Schedule 3). This measure will also simplify other aspects of the exemption.

Application

  • Parts 1 and 4 of Schedule 3 commence on the day on which this Bill is passed and receives Royal Assent.
  • Part 2 of Schedule 3 commences on 1 July 2000.
  • Part 3 of Schedule 3 commences immediately after the commencement of item 13 of Schedule 3 to the New Business Tax System (Miscellaneous) Act (No. 1) 2000.

Capital payments for trust interests (CGT event E4) (Schedule 4)

Schedule 4 corrects an error in the capital gains tax provisions. Under the existing law a payment by a trustee of a small business 50% reduction amount is incorrectly treated in determining in CGT event E4. Section 104-70 of the 1997 Act was amended by the New Business Tax System (Integrity and Other Measures) Act 1999. The introduction of the new small business CGT concessions by the New Business Tax System (Capital Gains Tax) Act 1999 requires consequential amendments to be made to section 104-70. The proposed measure deals with the determination of the non-assessable part of a payment to a beneficiary.

Application

The amendments made by Schedule 4 apply to assessments for the income year including 21 September 1999 and later income years, for CGT events that happen after 11.45 am (A.C.T. time) on 21 September 1999.

Technical correction (Schedule 6)

Schedule 6 contains a technical correction on excess deductions for mining or exploration expenditure.

Technical corrections (Schedule 8)

Schedule 8 contains technical corrections on deducting payments.

Consequential amendment of the dictionary provision of the 1997 Act (Schedule 9)

Schedule 9 contains consequential amendments of section 995-1, the dictionary provision of 1997 Act.

Endnotes

  1. A Tax System Redesigned, Review of Business Taxation Report (1999), pp. 615-620.

  2. A Tax System Redesigned, Review of Business Taxation Report (1999), p. 79.

  3. Minister's second reading speech.

  4. Subdivision 124-M was inserted into the 1997 Act by the New Business Tax System (Capital Gains Tax) Act 1999. The amending legislation was introduced into the House of Representatives on Thursday 25 November 1999 and was passed by the House on the same day. It was introduced into the Senate on Friday 26 November 1999 and passed by the Senate on Monday 29 November 1999.

  5. In a letter dated 24 November 1999 to the Deputy Leader of the Opposition, the Hon Simon Crean, MP, the Treasurer, the Hon Peter Costello, MP, stated that:

    We agree to the three points.

  1. Detail on the measures not yet before the Parliament are set out in the attachments.

I expect legislation containing measures dealing with alienation of personal services income, and non-commercial losses, will be available early next year. The Government proposes to pass it prior to 30 June 2000. As I have indicated to you I expect legislation on trusts to be prepared by 30 June next year and legislated in time to apply from 1 July 2001.

  1. The Government will introduce all the business tax changes announced in full.

  2. I have received advice from the Australian Taxation Office that your proposed integrity measure would not add to the Government's proposed strengthening of Part IVA. Having said that, if it were re-drafted in a workable form it would not detract from it either. If the Labor Party indicates its agreement to pass the Government legislation in the Senate the Government would include this clause if you want it. It is your election.

I am also enclosing copies of the two Bills which will be introduced into the Parliament tomorrow. These Bills provide incentives for investment in venture capital by non-resident tax-exempt super funds, streamline and extend small business CGT rollover relief provisions, provide scrip for scrip rollover relief and remove CGT averaging for individuals.

Since the Government has agreed to your three conditions, I look forward to your written confirmation that the Opposition will vote for the package in full.

Please confirm this as a matter of urgency.

(Source: Press Release (Treasurer) 24 November 1999)

  1. B Frith, 'Rewriting the scrip consigns the taxman to the wings', The Australian, !5 March 2000.

  2. ibid.

  3. The first method is a takeover where an offeror seeks control of a target company. The second method is a purchase of the business and assets of a target company and the third method is a scheme of arrangement. (H Ford, et al, Ford's Principles of Corporations Law (Butterworths, Sydney, 1999), para 23.020)

  4. Explanatory Memorandum to New Business Tax System (Miscellaneous) Bill (No. 2) 2000, para 11.25.

  5. The residency rules for companies are in section 6(1) of the Income Tax Assessment Act 1936.

  6. Explanatory Memorandum to New Business Tax System (Miscellaneous) Bill (No. 2) 2000, para 11.49.

  7. The concern expressed in the Explanatory Memorandum is that the exemption for foreign dividends under section 23AJ of the Income Tax Assessment Act 1936 (the 1936 Act) could be used to facilitate the tax free repatriation of low taxed profits. The exemption is provided because certain dividends have been fully taxed overseas. The exemption is designed to reduce administrative and compliance costs for taxpayers. If the exemption could be used, as asserted in the Explanatory Memorandum, to channel low taxed profits through a listed comparable country to obtain the exemption for foreign dividends, then there is a flaw in section 23AJ which will not be fixed by amending the scrip for scrip provisions. Moreover, this purported shortcoming in section 23AJ and avoidance opportunity have now been highlighted by the comments made in this Explanatory Memorandum.

  8. Explanatory Memorandum to New Business Tax System (Miscellaneous) Bill (No. 2) 2000, para 11.52.

  9. ibid.

  10. ibid., 11.53.

  11. (AGPS, Canberra, 1998), p. 120.

  12. ibid.

  13. Report, July 1999 (AGPS, Canberra, 1999).

  14. Review of Business Taxation, Report, July 1999 (AGPS, Canberra, 1999), p. 66.

  15. ibid., p. 489.

  16. See proposed paragraphs 320-15(e) to (f).

  17. Ordinary income is an abbreviation of the term 'income according to ordinary concepts'. Income according to ordinary concepts are receipts which courts have held to be assessable income.

  18. Receipts which have been included in the income tax base by legislation such as capital gains tax. The amounts that are to be included in the assessable income a life insurance company under proposed section 320-15 will be statutory income.

  19. Explanatory Memorandum to New Business Tax System (Miscellaneous) Bill (No. 2) 2000, para 5.47.

  20. This term is considered in the Concluding Comments for Schedule 2.

  21. ASFA media releases, ASFA, 'Proposed Solution to Self Managed Super Funds Tax Row', 4 May 2000.

  22. ibid.

  23. CPA media release, 27 April 2000.

  24. The Australian Financial Review, 6-7 May 2000, 'Banish the tax bogy with the clever use of entitlements'.

  25. The Australian Financial Review, 'Life firms mum on Ralph impact', Monday 1 May 2000.

  26. The Australian Financial Review, 5 May 2000.

  27. ibid.

  28. The Australian Financial Review, 'New tax slug for DIY super', Monday 22 May 2000.

  29. The Macquarie Dictionary (3rd edition).

  30. Item 16 of Schedule 2 of the Bill refers to the term 'notional capital gains'.

  31. Review of Business Taxation, p. 257.

  32. ibid., p. 256.

  33. Explanatory Memorandum to New Business Tax System (Miscellaneous) Bill (No. 2) 2000, para 1.21.

  34. See below.

  35. Schedule 2 of the Bill deals with applying income tax to life insurers. The measures in Schedule 2 are considered above.

Contact Officer and Copyright Details

Michael Kobetsky
Consultant
20 June 2000
Bills Digest Service
Information and Research Services

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ISSN 1328-8091
© Commonwealth of Australia 2000

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Published by the Department of the Parliamentary Library, 2000.

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